Bond Investments that Beat Inflation

The degree may vary, but most economists agree that inflationary pressures are re-emerging. A combination of factors, including a rising oil price, Trump’s reflationary fiscal policies and, in the UK, Brexit, are contributing to higher inflation expectations. Inflation has is an historic foe for bond markets and they have already begun to wobble.

The link between higher inflation and poor bond returns is well-established. As inflation rises, the fixed income paid by bonds has less value and therefore bonds sell off. However, bond markets are not entirely fallow ground for those looking to protect portfolios against inflation.

How to Beat Inflation

The most obvious choice is to select index-linked government bonds over their fixed income alternatives. Peter Lowman, chief investment officer at Investment Quorum says the shift from a low inflation, low interest rate environment to a rising inflation, rising interest rate could prompt a rotational switch from fixed interest securities into global equities and cash, but with some exposure to some index-linked paper.

He currently holds around 20% in index-linked bonds for his low risk clients. This chimes with other bond investors. BlackRock, for example, also currently favours inflation-linked securities over nominal bonds.

However, there are no bargains. In November of this year, the Bank of England launched a new 40-year index-linked government bond with the lowest ever inflation-adjusted return.

The issuance of £2.25 billion at an index-linked rate starting at 0.125% index-linked gilt gave a real yield, after current inflation, of -1.466%. The issuance was around 5 times over-subscribed, a reflection of the burgeoning popularity of index-linked bonds and a certain immunity to price.

As such, index-linked bonds may not fully solve the problem, but higher, inflation-protected yields are available in less liquid, niche areas of the bond market. John Patullo, manager of the Henderson Diversified Income Limited (HDIV), for example, has a high conviction position in secured loans. These are loans to companies, secured on corporate assets, but are higher up the pecking order in event of a default.

He says: “We have reasonably large allocations to this asset class in the portfolios. They are senior, first lien secured – in the event of a default, the lenders will be first to receive repayment from the liquidation of the company’s assets. They pay floating interest rates and thus have reduced interest rate sensitivity and benefit from low volatility, while providing a reasonable yield.”

The disadvantage is that they can be illiquid, but the investment trust structure helps manage this. The trust currently has an overall yield of 5.64%.

Convertibles: A Combination of Bonds and Shares

Another area of interest may be convertible bonds: JP Morgan Asset Management launched an investment trust focused on convertibles in June 2013 and it remains the only UK-listed vehicle. Convertible bonds combine characteristics of bonds and equities, paying a fixed income while holding the option to redeem at face value or convert into the company’s shares. As such, they tend to participate in any gains in the underlying share price and offer greater inflation protection.

Convertibles have not had a particularly good time relative to the wider debt sector, but Jonathan Stanford, senior fund manager in GAM’s non-directional equity team, believes they could prove interesting in 2017: “(They) seem a good fit for an environment in which nobody wants bonds and the majority are nervous about equities. The short duration characteristic of convertibles prevents over-exposure to rising interest rates.” Also, a higher proportion of the valuation comes from the performance of the company itself, rather than the interest rate/inflation environment.

Stanford adds: “The comparative competitiveness toward other assets will increase, prompting companies to choose convertible debt issuance over corporate bonds or bank loans. This will allow for more diversity, a renewed pool of assets and greater liquidity. The possibility of inflation, backed by stronger economic growth, would bode well for the equity market, and thus would allow convertible bonds to appreciate.”

Floating rate notes are also increasingly widely used, both by strategic bond managers and as specialist funds. Funds such as the NB Global Floating Rate Income or the M&G Global Floating Rate High Yield fund have attractive income yields of 4.25% and 2.84% respectively. Both have found resonance with investors, and are now £994 million and £899 million in size.

James Tomlins, manager of the M&G Global Floating Rate High Yield fund says companies are increasingly issuing this type of debt to vary the capital structure of their balance sheets. The market is now approximately $40 billion market in size with new issuers coming to the market.

Emerging Market Debt Offers Income

Emerging market debt may be another area that can weather a potential storm in bond markets. While there is no explicit inflation protection, it does look better value, with a higher yield and therefore should have a buffer if inflation rises in developed markets.

Even if inflation does not prove to be as potent as expected, this is unlikely to be a good time for many conventional bond markets, with valuations at historic highs. However there are selective opportunities for those willing to look to less conventional areas.

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